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Why is the APR on an adjustable rate loan lower than the interest rate on the loan?

 

When calculating the APR on an adjustable mortgage, we cannot just base it on the initial offered rate.  So the APR calculation has to take into account both the current rate and what the rate might be after 5 years. Of course, they don't have a crystal ball, so when calculating the APR they look at the value of the index now (the LIBOR rate which is 1.12%) and just assume that it will be the same 5 years from now.

So how does this affect the APR? The first 5 years of the loan will have an interest rate of 3.25%. But when you look at the index that will be used to calculate the variable part of the loan, the index-plus-margin at today's rate would be less than the initial rate. That is what is used to calculate the APR for this loan, and since the adjusted interest rate would be lower than the initial rate, it causes the APR to drop below the initial interest rate. It is impossible to calculate a definitive APR because of the variable nature of the loan, but this is the best that can be done given the amount of uncertainty inherent to the credit markets.

 

July 22, 2010

 

 

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